Practice Questions 4
1. On a downward sloping linear demand curve, total revenue would be at a maximum at the
a. midpoint of the demand curve.
b. lower end of the demand curve.
c. upper end of the demand curve.
d. It is impossible to tell without knowing prices and quantities demanded.
Answer: a
2. A legal minimum price at which a good can be sold is a price
a. cut.
b. stabilization.
c. ceiling.
d. floor.
Answer: d
3. A binding price ceiling causes
a. a shortage, which cannot be eliminated through market adjustment.
b. a surplus, which cannot be eliminated through market adjustment.
c. a shortage, which is temporary, since market adjustment will cause price to rise.
d. a surplus, which is temporary, since market adjustment will cause price to rise.
Answer: a
4. Suppose the government wants to alleviate the harm of smoking by reducing the consumption of
cigarettes, illustrate each of these proposed policies in a supply-and-demand diagram of the cigarette
market. On each graph, mark the initial equilibrium(Q1, P1)and the new price(P2) and new
quantity(Q2).
a. a tax on cigarette buyers
b. a tax on cigarette sellers
c. a price floor on cigarettes
d. a tax on tobacco suppliers
Answer:
a. The figure below shows the effect of tax on cigarette buyers. The tax reduces the demand for
cigarette from D1 to D2. The result is a rise in the price buyers pay for cigarettes from P1 to
P2, and a decline in the quantity of cigarettes from Q1 to Q2.
Price of
Cigarettes
Supply
P2
P1
P2 -tax
D1
D2
0
Q2
Q1
Quantity of
Cigarettes
b. The figure below shows the effect of tax on cigarette sellers. The tax reduces the supply for
cigarettes from S1 to S2. The result is a rise in the price buyers pay for cigarettes from P1 to
P2, and a decline in the quantity of cigarettes from Q1 to Q2.
S2
Price of
Cigarettes
S1
P2
P1
P2 -tax
Demand
0
c.
Q2
Q1
Quantity of
Cigarettes
The figure below shows the effect of a binding price floor on cigarettes. The increase in price
from P1 to Pf leads to a decline in the quantity of cigarettes from Q1 to Q2. There is excess
supply in the market for cigarettes since the quantity supplied(Q3)exceeds the quantity
demanded(Q2)at the price P1.
Price of
Cigarettes
Supply
P2
P1
Demand
0
Q2
Q1
Q3
Quantity of
Cigarettes
d. The figure below shows the effect of tax on tobacco producers. The tax reduces the supply for
cigarettes from S1 to S2 because tobacco is the main input of cigarettes. The result is a rise in
the price of tobacco from P1 to P2, and a decline in the quantity of cigarettes from Q1 to Q2.
S2
Price of
Cigarettes
S1
P2
P1
Demand
0
Q2
Q1
Quantity of
Cigarettes
5. The federal government uses the revenue from the FICA tax to pay for Social Security and
Medicare, the income support and health care programs for elderly. FICA is an example of a payroll
tax, which is a tax on the wages that firms pay their workers. The key feature of payroll tax is that it
places a wedge between the wage that firms pay and the wage that workers receive. Suppose the labor
market is like the following graph:
Wage($/hr)
Labor supply
Wage firms pay
Wage without tax
Tax wedge
Wage worers
receive
Labor demand
0
Q2
Q1
Quantity of
Labor(million hrs)
In this graph, the labor demand equation is PD=-0.1QD+7, the labor supply equation is PS=0.4QS-3.
The government wants to place a wedge of 1$/hr between supply and demand.
a. Find the equilibrium quantity and wage of this labor market before the government interferes in the
market;
Answer: From the demand and supply equation of labor market, it is easy to get QE=20million hrs,
WE=5$/hr.
b. Suppose the government places a excise tax of $1 per unit of labor on suppliers in this market.
i) What is the wage that firm will pay once this tax is imposed?
ii) What is the net wage that workers will receive once this tax is imposed?
Answer: i) 5.2$/hr; ii)4.2$/hr.
c. Compute the price elasticity of demand and supply of labor from Q1(the initial pre-tax
equilibrium)to Q2 (the after-tax equilibrium).
Answer: By the midpoint method(arc elasticity), we get |ED|=| [(18-20)/19]/[(5.2-5)/5.1] |=2.7, ES=
[(18-20)/19]/[(4.2-5)/4.6] =0.6.
d. Given the results in (c), will demanders of labor(firms) or suppliers of labor(workers) face a heavier
economic tax burden?
Answer: because 2.7>0.6, so workers face a heavier tax burden.
e. With the excise tax of $1 per unit of labor, what is the economic incidence of the tax on firms hiring
labor (i.e. consumer tax incidence)?
Answer:0.2$/hr.
f. With the excise tax of $1 per unit of labor, what is the economic incidence of the tax on suppliers
of labor (i.e. producer tax incidence)?
Answer:0.8$/hr.
g. How much tax revenue will the government collect from this tax?
Answer: 18million dollars.
h. What is the deadweight loss associated with this tax?
Answer: L=(20-18)*1*(1/2)=1 million dollars.
i. If the excise tax is doubled, how big is the deadweight loss?
Answer: 4 million dollars.
j. Does it matter if this tax is levied on suppliers or on demanders? Explain your answer.
Answer: No matter.
6. In 1973, OPEC raised the price of crude oil in world oil markets. Because crude oil is the major
input used to make gasoline, the higher oil prices reduced the supply of gasoline. Suppose that the
government, concerned about rising price due to OPEC’s actions, decided to subsidize consumers of
gasoline (in reality, the government enacted price controls instead of a subsidy in the early 1970’s).
The graph below illustrates both OPEC’s actions as well as the subsidy to consumers.
Suppose the supply equation of gasoline initially (S1) is PS1=QS1-1.5, the demand curve initially(D1)
is PD1=-QD1+4.5. After OPEC raised the price of crude oil, the new supply curve(S2) is PS2=QS2-0.5.
a. Initially, before OPEC’s action, what were the equilibrium quantity and equilibrium price in the
gasoline market?
Answer: QE1=3 million gallons, PE1=1.5$/gallon.
b. After OPEC raised the price of crude oil, What were the new equilibrium quantity and new
equilibrium price?
Answer: QE1=2.5 million gallons, PE1=2$/gallon.
c. Suppose the government subsidized consumers of gasoline an amount per gallon equal to the price
increase per gallon in (b),what is the new demand equation(D2)
Answer: PD2=-QD2+5.
d. Given OPEC’s actions and the subsidy in (c), what were the new equilibrium quantity and new
equilibrium price in the market?
Answer: QE2=2.75 million gallons, PE1=2.25$/gallon.
e. Based on (d)
i) what was the gross price the consumers of gasoline pay?
ii) What was the net price (net of the subsidy) that the consumers of gasoline pay?
iii) What was the price OPEC received?
iv) How much of the subsidy did the consumers of gasoline receive?
v) How much of the subsidy goes to OPEC?
Answer: The gross price the consumers of gasoline pay was 2.25$/gallon, the net price(net of the
subsidy) that the consumers of gasoline pay was 1.75$/gallon, the price OPEC received was
2.25$/gallon, 0.25$/gallon subsidy goes to car-drivers, and 0.25$/gallon subsidy goes to OPEC.
f. What’s the government’s total expenditure on the subsidy?
Answer: The total subsidy=0.5*2.75=1.375million dollars.
g. How much of the government’s expenditure on the subsidy did OPEC get?
Answer:0.25*2.75=0.6875million dollars goes to OPEC.
h. How much of the government’s expenditure on the subsidy did the consumers of gasoline get?
Answer: 0.6875 million dollars goes to the consumers of gasoline..
i. From this problem, what lesson would you get?
Answer: Even if the government subsidized the drivers by the same amount as the price increment due
to OPEC’s actions, the consumers of gasoline would not pay the same price as before OPEC raised
the price of crude oil. The effect of the subsidy depends on the relative elasticity of demand side and
supply side.